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Limits to Be Placed on Re-hypothecation

FSB is considering rules on whether and how banks should be allowed to use client assets as collateral for their own trades.

Brokers face restrictions on using clients’ assets as collateral for other trades, as part of a push by global regulators to prevent the securities lending market from sparking chain reactions that could cause a crisis.

Under recommendations published today by the Financial Stability Board (FSB), brokers wouldn’t be allowed to tap client assets for their own trading, and they would have to provide “sufficient disclosure” of plans to use the securities as collateral in other transactions. They would also have to meet minimum standards in managing liquidity risks.

Regulators are seeking to rein in how traders use collateral in a bid to prevent any repeat of the turmoil that followed the 2008 collapse of Lehman Brothers Holdings Inc., which was driven in part by confusion over who was owed what on outstanding trades. The European Union may seek to curb the number of times a single asset can be passed on as collateral in trades, a person familiar with the plans said last week.

“More safeguards” are needed for client assets, the FSB, which brings together regulators and central bankers from the Group of 20 nations, said in today’s proposals. Recycling the securities as collateral, a process known as re-hypothecation, “can create financial stability risks, especially if clients are uncertain about the extent to which their assets have been re-hypothecated or about the treatment in case of bankruptcy.”

Securities lending agreements are trades in which one party temporarily hands over a security to someone else in exchange for cash or other assets, and they are similar in many respects to repurchase agreements, or repos. Both markets are part of a $67 trillion shadow banking system that became a target for tougher rules following the collapse of Lehman.

Failure of a large player “may lead to sharp price falls that create mark-to-market losses for all holders of these securities. These losses can in turn lead to fresh rounds of fire sales by other firms, thereby creating an asset valuation spiral,” the FSB said.

Securities lending transactions and repos “play crucial roles in supporting price discovery and secondary market liquidity for a variety of securities,” the FSB said. The goal behind its recommendations is to prevent excessive leverage, and to “mitigate the risk that large forced sales of collateral in one market segment” spreads chaos throughout the broader financial system, it said.

Non-Banks

In addition to curbs on client-asset use, the FSB is calling for pension funds, insurers, and other non-banks active in these markets to face tougher rules, including liquidity requirements, when they reinvest cash collateral.

The FSB said that it would monitor implementation of the recommendations and report back to G-20 leaders in November 2014.

The plans stipulate that a minimum portion of cash collateral should be kept in short-term deposits, held in liquid assets such as “high-quality” government debt, or used for short-term transactions that can be readily converted into cash.

The FSB also published draft rules on the minimum costs non-banks should face when engaging in trades without using clearinghouses. The purpose of this rule is to make sure firms can’t get too much cash in exchange for low-quality collateral, the FSB said.

Regulators must ensure that firms don’t overreach in using these markets for short-term financing of long-term assets, some of which might become illiquid or lose value, the FSB said.

These trades can involve “maturity and liquidity transformation” that can present risks to the wider market if left unchecked, it said.

The FSB said it would seek views on this part of the recommendations and complete work on them by spring 2014.

The FSB published today’s report as part of a package of measures designed to oversee so-called shadow banking activities that allow banks to shift business off their balance sheets, as well as those which allow investors to bypass lenders and the functions they traditionally fulfill on the markets.

In addition to repos and securities lending agreements, the term also covers activities such as investments in money-market funds and securitization.

The FSB has been tasked by the Group of 20 nations with drawing up international rules to prevent shadow banking from sowing the seeds of the next crisis. Some measures, such as those for money-market funds, have already been published by standard setters.

Other parts of the FSB plans involve boosting companies’ disclosure of their repo and securities lending activities, and requiring them to do more internal stress testing of potential losses on these trades.

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